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The Financial Cycle and Macroeconomics: What Have we Learnt? (Claudio Borio)

I’ve read a few papers by Claudio Borio during the last year, and I usually find them instructive and challenging. In his latest working paper titled “The Financial Cycle and Macroeconomics: What Have we Learnt?”, Borio argues that present business cycle theories do not need to work on the their fine-tuning, but in re-thinking the business cycle process in itself. More specifically, Borio contrasts present business cycle theories, where the crises are triggered by an unexpected shock, to pre-WW2 theories where the bust was the consequence of an unsustainable boom. It is not just that the boom precedes a bust, but that the boom is -or can be- the cause of the bust.

The shift in focus on the key drivers of business cycles after WW2, Borio argues, set aside the role of the financial cycle in business cycle theories. Finance become to be considered a veil and, therefore, unneeded to understand business cycles. Only recently it has been under new consideration as a way to add friction to the business cycle process. The financial sector, however, being the market that channels loanable funds to different investment projects is a key player in business cycles, old and present. It is not easy to define what consists a financial cycle. Borio suggests to focus on changes in the perception of value and risk by agents in the financial market. After arguing for the importance of the financial market, Borio goes into explain essential features that require to be revisited in business cycle theories.

First, that the financial boom does not just precede the bust, but causes it. This is similar to the pre-WW2 theories of business cycles produced by distortions channeled through the credit market. Haberler’s Prosperity and Depression (1937) goes through different theories of this type.

Second, credit markets facilitate the purchase of asset that ultimately prove to be unprofitable investments. Misallocation of both, capital and labor, go on hidden in what seems to be a robust economy. The heterogeneity of capital and labor adds cost to the readjustment process. Borio argues that present business cycle theories suffer of two problems on this front. Either (1) this misallocation process is ignored or (2) it is added exogenously to the model rather than being an endogenous result.

Third, a point to which I’m also very sympathetic, is to differentiate between non-inflationary output gap and a sustainable output gap. The fact that any output gap is non-inflationary does not mean that an output gap can be filled with any economic activity. It is the right economic activity, the one that is sustainable by itself, what is needed to efficiently fill an output gap. It is quite possible, Borio points out, to go into an unsustainable path without clear signs of inflation (do the years prior to the 2008 financial crisis ring the bell?).

Borio mentions three potential ways to deal with these shortcomings. The first one is to move away from the model-consistent (“rational”) expectations. It is possible but artificial, Borio warns, to assume that economic agents have a full (and correct) understanding of the economy (see Caballero’s paper on the pretense of knowledge.) It should be added that to relax the rational expectations assumptions does not imply to bring into the model irrational behavior, but to acknowledge the presence of arational components (see Garrison’s “From Lachmann to Lucas: On Institutions, Expectations, and Equilibrating Tendencies”). To not know what is unknown is neither rational nor irrational.

A second possibility is to allow for changes in the behavior toward risk by economic agents. Under different economic contexts, agents asses and react differently to same levels of risk. I would add to this point to also account for Knight’s difference between risk and uncertainty.

Third, Borio continues, to bring back the monetary aspect of the economy into the business cycle models. Money is not a friction in the economy, but a necessary component that is present in all transactions and, because of this, a problem in the money market affects all the markets in the economy. When the creation of credit becomes unanchored of market fundamentals and driven by agents being too passive towards risky investment, misallocation of resources starts to be accumulated in the market. This means that business cycle theories need to move away its focus from equilibrium analysis towards disequilibrium analysis in the lines of Wicksell.

In addition, recessions may manifest differently. According to Borio, before the 1980s crises were triggered by tightening monetary policy to fight inflation. Actual crises are “balance sheet crises,” which is the result of a drop in the price of financial assets absent inflation. It could be argued, however, that the change in financial asset prices is the result of an excess of money supply that affects prices that fall outside the inflation calculation. The balance sheet crisis devolves into distinguishing two phases, crisis management and crisis resolution. The former consists in trying to avoid the implosion of the financial market. The latter’s objective is to repair the balance sheet. Borio warns that it would be a mistake, as Japan did, to try to fight a balance sheet crisis with fiscal policy and public spending. The problem is somewhere else. But Borio also says that this does not mean that the focus should be just on recapitalize banks without recognition of losses. The focus of the crisis resolution should not be credit quantity, but credit quality. It is not solution to keep afloat the credit structure that produced the misallocation of resources in the first place. This concern on quantity of credit can explain a weak potential GDP and the hysteresis of persistent output losses.

Another problem that Borio pays attention to is the problem of optimal currency areas. A monetary policy that look reasonable domestically are driven out economic problems beyond the country borders. A loose monetary policy of the central economies can translate to the rest of the world by small economies that fear to float and prefer to mimic the major central bank’s behavior.

Borio presents an interesting account of the macroeconomic theory standing in front of business cycles. It also present an Austrian flavor that has received attentoin after the 2008 financial crisis. This Austrian approach can bring light to places where mainstream economics has not paid attention. As Borio says at the beginning of his paper,

Understanding in economics does not proceed cumulatively. We do not necessarily know more today than we did yesterday, tempting as it may be to believe otherwise. So-called “lessons” are learnt, forgotten, re-learnt and forgotten again. Concepts rise to prominence and fall into oblivion before possibly resurrecting. They do so because the economic environment changes, sometimes slowly but profoundly, at other times suddenly and violently. But they do so also because the discipline is not immune to fashions and fads. After all, no walk of life is.